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(for a more detailed description see Section 2 below). We formalize this double-spending problem and show how this problem is being addressed by (i) a resource-intensive competition for updating the records of transaction – a process commonly referred to as mining – and (ii) by introducing con- firmation lags for settling transactions in cryptocurrency. This implies that a cryptocurrency faces a trade-off between how fast transactions settle and a guarantee (or “finality”) for their settlement. Consequently, crytocurrencies cannot achieve immediate and final settlement of transactions. A strength of our analysis is that we take into account the costs of operating a cryptocurrency that prohibits double-spending. This allows us to quantitatively assess how efficient Bitcoin as a medium of exchange can be relative to existing means of payment. Calibrating our model to Bitcoin data, we find that from a social welfare perspective using Bitcoin is close to 500 times more costly than using traditional currency in a low inflation environment. This is, however, a result of the inefficient design of Bitcoin as a cryptocurrency. Bitcoin uses both currency growth and transaction fees to generate rewards for mining. In its current form, the cryptocurrency reward structure is too generous so that too many resources are being used to rule out double-spending and making it a secure form of payment. We show that the optimal way of providing rewards for mining is exclusively via currency creation at a very low rate rather than by using transaction fees. The optimal design of Bitcoin would generate a welfare cost of only about 0.08% of consumption which is equivalent to a cash system with moderate inflation. We also evaluate the efficiency of using a cryptocurrency system to support large-value and retail transactions. Using summary data for Fedwire and US Debit cards, we confirm that cryptocur- rencies are a much better alternative for low value, high-volume transactions than for large value payments. This is intuitive, as double spending incentives increase with the size of transactions. Hence, more mining and longer confirmation lags (which are both costly) are required when sup- porting large-value payments in a cryptocurrency. Our exercise shows that cryptocurrency systems can potentially be a valid alternative to retail payment systems that operate at very low fees, as soon as limits on the scale of such systems can be resolved. The economic literature on cryptocurrencies is very thin. We are not aware of any work that has formalized the design features of a cryptocurrency and that has studied its optimal design under the threat of double spending attacks. We model bilateral exchange based on money, we follow the recently promoted framework of Lagos and Wright (2005) and enrich it by modelling a mining competition to update the blockchain. For formalizing the blockchain itself, we rely on the 3PDF Image | The Economics of Cryptocurrencies Bitcoin and Beyond
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